UK Executive Stock Option Valuation: A Conditional Model

• Published date: 01 November 2007
• Author: Konstantinos Vonatsos,Edward Lee,Konstantinos Stathopoulos
• DOI: http://doi.org/10.1111/j.1467-8683.2007.00658.x
• Date: 01 November 2007

UK Executive Stock Option

Valuation: A Conditional Model

Edward Lee, Konstantinos Stathopoulos* and

Konstantinos Vonatsos

We value UK executive stock options (ESOs) as American options that are awarded condi-

tional on the probability of the holders achieving some performance criteria. Unlike the

standard Black and Scholes (BS) model, which is universally used both in the literature and

practice, this provides a more realistic representation of UK ESOs. We show that UK ESOs

actually have less value and contain more incentives than they appear under the BS

approach. Specif‌ically, we observe a 17 per cent average discount in the value of the ESOs

when compared to their BS value. In addition, we f‌ind signif‌icantly higher incentive levels

when we measure the sensitivity of the options using the hedge ratio, i.e. the option’s delta.

We argue that these f‌indings have implications for two contemporary debates in the UK, i.e.

the substitution of ESOs by Long-Term Incentive Plans (LTIPs) and the discounting of ESO

value from company prof‌its.

Keywords: Managerial compensation, executive stock options, option valuation

Introduction

Executive Share Options (ESOs) have

attracted much controversy in recent

years. During the early 1990s they were hailed

as the most effective tool for relating executive

pay to corporate performance and aligning

the interests of managers and shareholders.

This resulted in the widespread use of ESOs

on both sides of the Atlantic. According to

Hall and Liebman (1998), stock options have

emerged as the single largest component of

compensation for U.S. executives. In f‌iscal year

1998, the grant-date value of stock options

accounted for 40 percent of total pay for S&P

500 CEO’s, up from only 25 percentof total pay

in 1992. Almost the same f‌igures applied for

high market capitalisation, well-established

UK f‌irms (Conyon and Schwalbach, 2000).

Conyon, Gregg and Machin (1995) also pin-

pointed a marked increase in the use of share

incentive schemes or share options, during the

1990s, for a wide range of UK companies.

In recent years though, ESOs have been

accused of over-rewarding managers. In the

UK, policy makers have started calling for the

replacement of ESOs by long-term incentive

plans (LTIPs), which typically consist of

restricted shares (Greenbury, 1995). These rec-

ommendations have been supported by both

institutional inventors and the f‌inancial press

and as a result there is a notable shift from

ESOs to LTIPs especially for well-established,

high market-capitalisation f‌irms that typically

attract more public scrutiny (Monks Partner-

ship, 1996). In addition, the academic commu-

nity has always been hesitant to accept ESOs as

the panacea to the agent-principal problem.

The reasons for this reluctance have both a

practical and a theoretical dimension. On a

practical level, the empirical results produced

by various studies have suggested a weak link

between executive pay packages (including

stock options) and corporate performance and

often contradictory results have been pre-

sented (for a review see Murphy, 1999). In any

case, increases to pay-performance sensitivity

during the 1990s appear to be largely a phe-

nomenon associated with large companies

(Murphy, 1999). On a theoretical level, several

*Address for correspondence:

Accounting and Finance

Group, Manchester Business

School, MBS Crawford,Oxford

Road, Manchester M15 6PB,

UK. Email: k.stathopoulos@

mbs.ac.uk

UK EXECUTIVE STOCK OPTION VALUATION 1469

Volume 15 Number 6 November 2007

© 2007 TheAuthors

Journal compilation © 2007 BlackwellPublishing Ltd, 9600 Garsington Road,

Oxford, OX4 2DQ, UK and 350 Main St,Malden, MA, 02148, USA